US financial watchdog reports deficiencies in big accountancy firms' audit work

In a new report, the Public Company Accounting Oversight Board (PCAOB) said (31-page / 118KB PDF) that inspections it had made in 2010 of eight firms, including Deloitte & Touche, Ernst & Young, KPMG, Grant Thornton and PricewaterhouseCoopers (PwC), had revealed "deficiencies" in the way some accounts had been audited in 2009.

PCAOB said that in 15% of the "integrated audit engagements" it had analysed, its inspectors had found that the auditors had "failed to obtain sufficient audit evidence to support its audit opinion on the effectiveness of internal control due to one or more deficiencies identified". It said in 39 of the 309 audits it reviewed "where the firm did not have sufficient evidence to support the internal control opinion ... the firm also failed to obtain sufficient audit evidence to support the financial statement audit opinion."

The "most pervasive deficiencies" that were identified included firms' failure to "identify and sufficiently test controls that are intended to address the risks of material misstatement" and to "sufficiently test the design and operating effectiveness of management review controls that are used to monitor the results of operations", such as by comparing monthly budgets with actual results and comparing profits and some expenses "as a percentage of sales", PCAOB said.

The watchdog said that workload pressures, failure to properly apply a "top-down approach" to auditing activities, insufficient training and guidance and "ineffective" communication may have been among the "potential root causes" of the "deficiencies" its inspectors had identified.

"It appears that firms need to perform more thorough analyses of both the risk of material misstatement and the approach taken to auditing internal control," PCAOB said in its report. "Deficiencies identified in firms' testing and assessment of controls generally contributed to deficiencies in firms' substantive audit procedures to test account balances and transactions, as the nature, timing, and extent of firms' substantive procedures were based on a control reliance approach that was not supported by the audit procedures performed."

"Firms should perform their own root cause analyses for the deficiencies identified in this report, if applicable, and take appropriate corrective action. Firms need to monitor and evaluate whether their corrective actions adequately address the deficiencies identified in this report," it added.

PCAOB said that inspections undertaken in 2011 had showed that "deficiencies in the auditing of internal control are continuing to occur", with 22% of opinions formed by auditors being "insufficiently supported", according to the figures from the accounts that inspectors have so far analysed. It said that the failings were not limited to just the eight firms it has inspected.

"The Board's inspections have found similar problems with audits of internal control at other registered firms," PCAOB said. "Therefore, all registered firms should review this report and consider whether the auditing deficiencies that the Board has observed could manifest themselves in their practices."

"Firms should be proactive in considering how to prevent similar deficiencies, through strong firm quality control systems, robust training and guidance and by seeking ways to better anticipate and address risks that might arise in specific issuer audits," it added.

"Audit committees may consider inquiring of the issuer's auditor how the controls to be tested will address the assessed risks of material misstatement for relevant assertions of significant accounts and disclosures. Also, audit committees may consider discussing with the auditor his or her assessment of risks, evaluation of control deficiencies, and whether the auditor has adjusted as necessary the nature, timing, and extent of his or her control testing and substantive audit procedures in response to risks related to identified control deficiencies," the watchdog said.

The report by PCAOB comes just days after the US Securities and Exchange Commission (SEC) charged Chinese affiliates of "the big four" accountancy firms – Deloitte and Touche, Ernst & Young, KPMG and PwC – with failing to hand over "audit work papers and other documents related to China-based companies under investigation by the SEC for potential accounting fraud against US investors".

SEC said that it is currently investigating nine China-based firms that publicly trade on the US markets but that the "audit firms" had failed to cooperate with its request for materials.

“Only with access to work papers of foreign public accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud," Robert Khuzami, director of the SEC’s division of enforcement, said in a statement last week. "Firms that conduct audits knowing they cannot comply with laws requiring access to these work papers face serious sanctions."

Also in the US, a Hewlett-Packard (HP) shareholder has launched a legal case against Deloitte and KPMG, claiming that the auditors had "consciously disregarded numerous red flags" related to the value of UK firm Autonomy that caused HP to buy the software business at an inflated price last year, according to a recent report  by the BBC.

Last month HP reported that its purchase of Autonomy had cost its software business $8.8 billion, but attributed "the majority of this impairment" to "serious accounting improprieties, disclosure failures and outright misrepresentations at Autonomy" which it said "occurred prior to HP's [£7 billion] acquisition of Autonomy" in 2011 and which affected the "trading value" of shares, it claimed.

HP's claims prompted Dr Mike Lynch, Autonomy's former chief executive to fervently deny the allegations.

However, HP shareholder Philip Ricciardi is suing Deloitte and KPMG, among others, accusing the auditors of playing a part in the alleged misrepresentation of Autonomy's value.

At the time Chris Wheeler, a forensic accountant at Pinsent Masons, the law firm behind Out-Law.com, said that companies should be aware that there are limitations in what they can glean about other firms from reviewing their accounts.

"The financial statements can only ever provide some assurance that the historic performance as dictated by the accounting policies adopted by the company in their preparation was true and fair – in other words that the auditors were satisfied that the Directors had produced numbers and disclosure in accordance with the relevant accounting standards which was fairly stated within their view of what was material, and properly prepared in accordance with the Companies Act," Wheeler said.